Timcom99 wrote:Yep, you are right Keith. Vanguard will get it right as it always has.

As it mostly has. By their own admission, they have been dinking with their Target Retirement Funds for competitive reasons. Now, they are dinking with bond allocations in their LifeStrategy and Target Funds for cosmetic reasons?

Strikes me as much the same process that led GM to believe in the Pontiac Aztec.

abuss368 wrote:Everytime this subject come up, I consider David Swensen's thoughts from the excellent book "Unconventional Success":

"By asset size, foreign-currency-denominated bonds represent a formidable market, falling just short of the aggregate market value of U.S.-dollar-denominated debt. Yet, in spite of the market's size, foreign bonds offer little of value to U.S. investors."

"Consider bonds of similar maturity and similar credit quality, with one denominated in U.S. dollars and the other denominated in foreign currency. Because monetary conditions differ from country to country, the two bonds would likely promise different interest rates. An investor might expect that different interest rates and different economic conditions would lead to different investment results. If, however, the investor hedges each of the foreign bond's cash flows by selling sufficient foreign currency in the forward markets to match the anticipated receipt of interest and principal payments, then the U.S. dollar cash flows of the dollar-denominated bond match exactly the U.S. dollar cash flows of the foreign-currency-denominated bond hedged into U.S. dollars."

That is not how hedged bond funds work. What is being hedged is currency, not the stream of bond payments. (If you want a deterministic stream of payments, then you don't want any kind of bond fund - you want a bond ladder).

For example, if an Australian bond fund investor experiences a return 1% higher than Australian$ cash over some period of time, then a hedged U.S. investor in Australian bonds would ideally experience a return 1% higher than US$ cash. This will generally not be identical to the return of U.S. dollar bonds.

The quotes were right out of David Swensen's book Unconventional Success. I can provide page numbers if you would like to see yourself. Are you implying Dr. Swensen is incorrect?

The statement ("If, however, the investor hedges each of the foreign bond's cash flows...") is technically correct, but it doesn't apply to bond funds. It applies to a (fixed, non-rolling) bond ladder.

So yeah, I think Swensen made a mistake, since I don't think he meant to restrict his analysis to bond ladders.

I can tell you it was not related to individual bonds. I know for a fact he also means international bond funds. He does not like international bonds or bond funds!

The Australian bond example doesn't work because the forward exchange rate would adjust for the difference in interest rates. It's an arbitrage relationship. e.g, if the forward rate were the same as the spot rate, you could sell your US bonds, convert to Austrailian$ at the spot rate and purchase the Austrailian bond. You would be able to lock in the rate to convert back to US$ at maturity by doing a forward trade now. This wlll give you an almost certain profit of 1%, which you can do as much as you want. The same works in reverse if forward rates were more than the difference in bond interest rates. This arbitrage means that forward exchange rates must equal the difference in the interest rates in two country's bonds, assuming that they have the same credit quality.

dex wrote:You would be able to lock in the rate to convert back to US$ at maturity by doing a forward trade now. This wlll give you an almost certain profit of 1%, which you can do as much as you want. The same works in reverse if forward rates were more than the difference in bond interest rates. This arbitrage means that forward exchange rates must equal the difference in the interest rates in two country's bonds, assuming that they have the same credit quality.

But what about the inevitable changes in credit quality over time? Bonds from different countries are likely to experience very different default rates and future credit prospects as they age, based on local conditions. Your arbitrage model works fine until something unexpected impacts the credit quality of the bonds from a given country, but doesn't impact the exchange rate in a like manner.

These funds hold both corporate and government bonds and I don't think the interest rate/exchange rate interlock is nearly as robust as you suggest.

The huge outflow of money will cause its Expense Ratio to go up me thinks.

Well, as long as you're making predictions anyway, how about some indication of magnitude and not just direction? Just how bad a "beating" are we talking about? I'm currently holding VBTLX, Total Bond Market Admiral shares, with an 0.10% ER. I don't want to pin you down to unreasonable precision, just some rough idea.

Not that matters in a significant way, but Fidelity Spartan US Bond Index Adv (FSITX) has its expense ratio capped at .10% at least until late 2014. Who knows after that but don't they usually keep these caps in place after expiration?

Now, for an unhedged bond, all those factors are at play. For a hedged bond, the short currency contract eliminates the currency changes and effectively converts the foreign risk-free rate to the domestic risk-free rate. So hedging strips away the noise in bond returns (currency movements) and gives pure exposure to traditional risk/return dimensions.

The benefit of non-US hedged bonds, therefore, is that at any point in time, global credit and term spreads are less than perfectly correlated (so there is a diversification benefit to a periodically rebalanced portfolio), and you lower the risk that you are exposed to only one bond market whose term and credit premiums are negative for an extended period and bond returns are poor (call it the "Japan problem" applied to bonds).

Incidentally, global bond strategies can be structured to maximize the potential term/credit opportunities by shifting exposure to the countries with the steepest yield curves and/or the widest credit spreads, as steep curves and wide spreads tend to indicate high future term and credit premiums. Even without this additional step, I still see benefits in diversifying bonds globally while hedging currencies.

The huge outflow of money will cause its Expense Ratio to go up me thinks.

Well, as long as you're making predictions anyway, how about some indication of magnitude and not just direction? Just how bad a "beating" are we talking about? I'm currently holding VBTLX, Total Bond Market Admiral shares, with an 0.10% ER. I don't want to pin you down to unreasonable precision, just some rough idea.

Not that matters in a significant way, but Fidelity Spartan US Bond Index Adv (FSITX) has its expense ratio capped at .10% at least until late 2014. Who knows after that but don't they usually keep these caps in place after expiration?

You are right, and although I eventually closed my Fidelity account and don't follow Fidelity stuff as closely as before, it's my impression that they have never let a cap expire. That is, there's not a shred of evidence for the caps being teaser deals or bait-and-switch.

I clicked too soon and didn't read the footnote. I was actually surprised to see the 0.17% as I had thought the ER was identical. I had actually intended to say something like "if the expense ratio goes up for Vanguard Total Bond, what would stop me from simply exchanging it for something like FIdelity Spartan U. S. Bond Index?" Point being the NAV is the NAV, and, unlike an ETF, when you sell you are guaranteed to get the end-of-day NAV, and any problems with redemptions are the fund's problem, not mine.

nisiprius wrote:You are right, and although I eventually closed my Fidelity account and don't follow Fidelity stuff as closely as before, it's my impression that they have never let a cap expire. That is, there's not a shred of evidence for the caps being teaser deals or bait-and-switch.

In this and other threads, some have suggested this new fund shows Vanguard is just bowing to market pressures and has strayed from the ideals of Mr. Bogle. However, I stumbled on this old post from 2009 by petrico that links to a Money article from 2004.

A sample portfolio offered by Mr. Bogle back in 2004 included a 10% allocation to PIMCO's foreign bond fund.

A lot can happen in 9 years and I'm not sure what Mr. Bogle has written about international bonds since then, but this shows Mr. Bogle is flexible about international bonds having a place in a well constructed portfolio.

Jim

Last edited by magellan on Sun Feb 10, 2013 11:55 am, edited 2 times in total.

I believe the biggest risk one is mitigating against is US government default. However, given how integrated world economies are, I am doubtful that the rest of the world's bonds (particularly the largest weights of Japan, France, Germany, and England) will be doing well in the event of a US default. But markets and economies can and do surprise, and in many years, things could look much different.

I also dislike the fact that this fund has a 23% weight to Japan. I know we all generally believe in efficient markets, but weighting 20% of a fund to the world's most indebted government (240% of GDP and rising 7%+ per year, while at the same time receiving among the lowest of returns (JGB 10-yr yield is 0.77%), seems inconsistent with the risk-reward trade-off. With equities, I agree with the market-weighting. When it comes to bonds and debt issuance, particularly government bonds, I am not so sure about market-weighting....

dex wrote:You would be able to lock in the rate to convert back to US$ at maturity by doing a forward trade now. This wlll give you an almost certain profit of 1%, which you can do as much as you want. The same works in reverse if forward rates were more than the difference in bond interest rates. This arbitrage means that forward exchange rates must equal the difference in the interest rates in two country's bonds, assuming that they have the same credit quality.

But what about the inevitable changes in credit quality over time? Bonds from different countries are likely to experience very different default rates and future credit prospects as they age, based on local conditions. Your arbitrage model works fine until something unexpected impacts the credit quality of the bonds from a given country, but doesn't impact the exchange rate in a like manner.

These funds hold both corporate and government bonds and I don't think the interest rate/exchange rate interlock is nearly as robust as you suggest.

Jim

My explanation of the arbitrage mechanism was, incorrectly, trying to fit the usual arbitrage argument into this bond example. I actully think that the arbitrage is done by big international banks who can borrow and lend at a small interest spread in many currencies. The arbitrage doens't force a single forward rate but gives a range because no one can really borrow and lend at the same rate.

Is the product live yet? I'm trying to find data about the fund's geographical distribution. Is this going to be an EU-centric bond like BWX or a true total international, which includes "developed" economies in Asia like S.Korea, Pacific region countries like Australia and the always neglected Canada in traditional international indexes like EAFE...

What is the point of holding an international bond fund that is hedged to remove the diversification benefit of international bonds?

I'm going to go ahead and call it that 10 years from know, some of these threads about the Boglehead approach to "currency risk" will be featured on a top ten list of "The most cringe-worthy moments in Investing" ... right along the threads about house flipping in 2006.

Chan_va wrote:If better yields is what you are after, why not just increase your equities allocation? Do intnl bonds have a different correlation to stocks and bonds? Portfolio diversification means nothing unless one component of the portfolio zigs when the other zags.

Otherwise it's like diversifying from an all ice cream diet by adding gelato.

You don't have to have negative correlation to get the benefits of diversification. Most stocks are positively correlated, and yet you benefit from diversification because they aren't PERFECTLY correlated. Vanguard's literature shows that increasing your international bond exposure to up to 40% of your overall bond exposure improves diversification. That's ostensibly the reason for adding it to a portfolio.

Bustoff wrote:Anyone know what risk level Vanguard will assign to this fund ?

Will Vanguard account holders get an opportunity to invest before the institutional money drives up the price ?

It should get a rating of "5". Ever own an international bond? Ask institutional money managers who were holding Argentian bonds in 1999 how reliable foreign governments are when it comes to paying back loans. They tore up the promissory notes and basically said, we'll give you back 35 cents on the dollar (that was only after the threat of bringing the matter before the courts), before that the offer was zero. So, most people lost 65% on bonds that were yielding 9% at issuement, the year prior. Still want to own International Bonds based on the ah hem, "full faith and credit" of we can do whatever we want with your money?

You can make the same argument for *not* having a large allocation to US government debt (and thus *for* allocating a whole lot to this fund), esp. since the US government has technically defaulted twice in the last 100 years.

An unhedged International Bond Fund would be useful in protecting against the possibility of Fed QE25+ printing so many dollars that the dollar gets crushed.

International equity already does this. As do commodities if you can find a fund that isn't broken. The hedged bond fund gives you exposure to other countries' interest rates which do not always move in tandem with US rates. If it were unhedged, the currency volatility would swamp the interest rate diversification benefit and there'd probably be no real point to this vs. an international stock fund.

normaldude wrote:So for diversification purposes, it makes sense to have part of your bond portfolio in non-USD, so whether the dollar skyrockets or crashes, you're covered either way.

From the point of view of someone living, earning, and spending in the United States, the dollar doesn't skyrocket or crash. A dollar is worth a dollar, by definition. I do not need to call up the bank to find out today's price on a roll of quarters; it is $10.00.

I am concerned about inflation, the possibility that a dollar may buy less stuff, but the obvious response to that is to use financial instruments that are linked to inflation.

Well the reason you'd be concerned is because a less valuable dollar buys less stuff internationally which means the cost of anything that's a global market or that the US has to import goes up. As for inflation linked securities, the risk you are taking there is that the US government could just redefine CPI again to reduce your returns from what you had expected...

Akiva wrote:If it were unhedged, the currency volatility would swamp the interest rate diversification benefit and there'd probably be no real point to this vs. an international stock fund.

Actually, Vanguard's Global Fixed Income whitepaper (linked earlier in the thread) shows that at the portfolio level, which is all that really matters, adding up to 20% unhedged bonds doesn't meaningfully impact portfolio volatility. Sure, if you go with 100% foreign bonds, you see a giant volatility spike, but that's not what anyone is going to do with this asset class.

I found it interesting that their own chart demonstrated that skipping the hedging doesn't increase volatility, yet elsewhere in the doc they made the case for hedging using a discussion of the high volatility of the asset class in isolation.

Jim

Last edited by magellan on Wed Feb 13, 2013 6:55 am, edited 2 times in total.

dex wrote:The Australian bond example doesn't work because the forward exchange rate would adjust for the difference in interest rates. It's an arbitrage relationship. e.g, if the forward rate were the same as the spot rate, you could sell your US bonds, convert to Austrailian$ at the spot rate and purchase the Austrailian bond. You would be able to lock in the rate to convert back to US$ at maturity by doing a forward trade now. This wlll give you an almost certain profit of 1%, which you can do as much as you want. The same works in reverse if forward rates were more than the difference in bond interest rates. This arbitrage means that forward exchange rates must equal the difference in the interest rates in two country's bonds, assuming that they have the same credit quality.

As reasonable as this sounds, forex markets don't actually work that way b/c the carry trade (borrowing money in low interest rate countries, converting it to a high interest rate currency, earning interest on it, and converting it back) has earned positive returns for a very long period of time. (Despite the record having "peso problem" events and the like.)

There's a famous paper by Robert Hodrick that goes into all the gory details about the historic data and basically concludes that no existing financial model (circa 1987) could account for the historic returns record.

magellan wrote:Actually, Vanguard's Global Fixed Income whitepaper (linked earlier in the thread) shows that at the portfolio level, which is all that really matters, adding up to 20% unhedged bonds doesn't meaningfully impact portfolio volatility. Sure, if you go with 100% foreign bonds, you see a giant volatility spike, but that's not what anyone is going to do with this asset class.

I found it interesting that their own chart demonstrated that skipping the hedging doesn't increase volatility, yet elsewhere in the doc they made the case for hedging using a discussion of the high volatility of the asset class in isolation. In other words, it was like they were saying "We've made up our mind, let's not get confused by the data."

Jim

For a portfolio with 30% foreign stocks & 30% foreign bonds, the standard deviation is 9.9 for unhedged vs. 9.6 for hedged. For a portfolio with 50% foreign stocks & 50% foreign bonds, the standard deviation is 10.3 for unhedged vs. 9.7 for hedged. When comparing figure 4 & figure 8, the standard deviation for a given stock mix tends to go down with the addition of hedged foreign bonds & up with the addition of unhedged foreign bonds. Vanguard appears to have chosen a hedged foreign bond fund as a way of decreasing portfolio volatility. If the returns of the hedged foreign bonds are similar to that of domestic bonds, then this could be a useful addition to a portfolio.

apex84 wrote:For a portfolio with 30% foreign stocks & 30% foreign bonds, the standard deviation is 9.9 for unhedged vs. 9.6 for hedged. For a portfolio with 50% foreign stocks & 50% foreign bonds, the standard deviation is 10.3 for unhedged vs. 9.7 for hedged. When comparing figure 4 & figure 8, the standard deviation for a given stock mix tends to go down with the addition of hedged foreign bonds & up with the addition of unhedged foreign bonds. Vanguard appears to have chosen a hedged foreign bond fund as a way of decreasing portfolio volatility. If the returns of the hedged foreign bonds are similar to that of domestic bonds, then this could be a useful addition to a portfolio.

Even over long time periods, would an average investor, let alone a reasonably astute Boglehead really "feel" the difference between a std of 9.9 and 9.6 besides the fact that it came out mathematically (let's assume annualized returns are exactly the same)? I wonder at what level of volatility change would most investors start to "feel" it?

I'm all for lower std for same return, but throw this question out.

RM

I figure the odds be fifty-fifty I just might have something to say. FZ

Random Musings wrote:Even over long time periods, would an average investor, let alone a reasonably astute Boglehead really "feel" the difference between a std of 9.9 and 9.6 besides the fact that it came out mathematically (let's assume annualized returns are exactly the same)? I wonder at what level of volatility change would most investors start to "feel" it?

Right. But IMO, even this overstates the impact.

A typical boglehead allocation would probably be something like 10%-20% of bond holdings to foreign bonds. Say 20% of bonds or 10% of the overall portfolio as Mr. Bogle recommended in that 2004 portfolio I posted earlier.

With that, we're talking about a rounding error in terms of the difference in volatility between hedged and unhedged.

magellan wrote:In this and other threads, some have suggested this new fund shows Vanguard is just bowing to market pressures and has strayed from the ideals of Mr. Bogle. However, I stumbled on this old post from 2009 by petrico that links to a Money article from 2004.

A sample portfolio offered by Mr. Bogle back in 2004 included a 10% allocation to PIMCO's foreign bond fund.

A lot can happen in 9 years and I'm not sure what Mr. Bogle has written about international bonds since then, but this shows Mr. Bogle is flexible about international bonds having a place in a well constructed portfolio.

Jim

Mr. Bogle's point has always been that if you're well diversified across stocks and bonds, and keep your costs low, you're good - and he has repeatedly said that simply TSM + TBM is good enough, and if you want to add this, and that, and that other one too, it's all fine if done in moderation - as long as the broad principle of diversification + low costs is in place - because the rest are just details.

Too much was read into that particular portfolio suggestion in that article, which Mr. Bogle described as something he casually suggested. He was asked about it during Bogleheads reunion in Vegas, and he said he thought foreign bonds unnecessarily complicates the portfolio.

apex84 wrote:For a portfolio with 30% foreign stocks & 30% foreign bonds, the standard deviation is 9.9 for unhedged vs. 9.6 for hedged. For a portfolio with 50% foreign stocks & 50% foreign bonds, the standard deviation is 10.3 for unhedged vs. 9.7 for hedged. When comparing figure 4 & figure 8, the standard deviation for a given stock mix tends to go down with the addition of hedged foreign bonds & up with the addition of unhedged foreign bonds. Vanguard appears to have chosen a hedged foreign bond fund as a way of decreasing portfolio volatility. If the returns of the hedged foreign bonds are similar to that of domestic bonds, then this could be a useful addition to a portfolio.

Even over long time periods, would an average investor, let alone a reasonably astute Boglehead really "feel" the difference between a std of 9.9 and 9.6 besides the fact that it came out mathematically (let's assume annualized returns are exactly the same)? I wonder at what level of volatility change would most investors start to "feel" it?

I'm all for lower std for same return, but throw this question out.

RM

Investors probably won't feel the difference in standard deviation, but they would feel the different event risk of hedged vs unhedged. Most investors think of bonds as doing well in deflationary environments, but an unhedged fund would lose value in dollar terms if the US had deflation. (The reverse is true for inflation.) So this seems to me to be a case of making the fund's behavior be in line with investor expectations.

Perhaps in a way, the hedged vs unhedged foreign bond question is similar to the "Treasuries vs TIPS" question. In other words, Treasuries are to TIPS are what unhedged foreign bonds are to hedged foreign bonds. In both cases, there's a risk that you can neutralize from the asset if you wish. With treasuries, the risk is inflation and with foreign bonds, the risk is the currency value.

Treasury holders get some diversification benefit from hanging onto that inflation risk, just as unhedged foreign bond holders may get a diversification benefit from the currency risk. Also, in the unhedged bond case, investors get to pocket the savings on hedging costs.

Like the treasuries vs TIPS debate, this is another case where we're probably doomed to talk ourselves in circles since there isn't really a knowable right answer, except to choose a path that you're comfortable with and stay the course.

I just remembered some other considerations in Vanguard's defense on this hedged vs unhedged question. I can't remember if I posted this before.

On our outing to Vanguard HQ at the Bogleheads conference last year, I was in a small group chatting with one of the Vanguard panelists about the hedged vs unhedged foreign bond question (how many places in the world could an average investor have that chat?).

Anyhow, one factor the Vanguard guy mentioned was that Vanguard was concerned about attracting hot money and they felt that an unhedged foreign bond fund, with the lowest cost in the industry, could be 'too' attractive to traders and speculators. That would mean lots of unsteady flows that would make the fund harder to run. They believed a hedged foreign bond fund was much less likely to attract hot money. Perhaps you could make the argument that this benefit negates the cost of hedging.

IIRC, during this same informal side discussion, the Vanguard panelist also confirmed that Nisi's 'do no harm' principle was in play as well.

I interviewed Ken Volpert,Vanguard head of taxable bonds, and learned the hedging costs will about to between 0.05 and 0.10% annually. Thus the all in expenses should be about 0.25 to 0.30% annually for the Admiral and ETF share classes.

Allan Roth wrote:I interviewed Ken Volpert,Vanguard head of taxable bonds, and learned the hedging costs will about to between 0.05 and 0.10% annually. Thus the all in expenses should be about 0.25 to 0.30% annually for the Admiral and ETF share classes.

Random Musings wrote:Even over long time periods, would an average investor, let alone a reasonably astute Boglehead really "feel" the difference between a std of 9.9 and 9.6 besides the fact that it came out mathematically (let's assume annualized returns are exactly the same)? I wonder at what level of volatility change would most investors start to "feel" it?

I agree that the benefits as described in the white paper are small. I still think that the availability of a low cost fund from Vanguard that tracks the largest asset class in the world is a useful addition to their fund offerings. Even if the benefits of the fund are slim in the current bond environment, it is possible that this diversification will be useful in the future. Of course, like all diversifying assets, it has a chance of lowering portfolio return, but at least with bonds, one knows the yield at the outset.

Random Musings wrote:Even over long time periods, would an average investor, let alone a reasonably astute Boglehead really "feel" the difference between a std of 9.9 and 9.6 besides the fact that it came out mathematically (let's assume annualized returns are exactly the same)? I wonder at what level of volatility change would most investors start to "feel" it?

I agree that the benefits as described in the white paper are small. I still think that the availability of a low cost fund from Vanguard that tracks the largest asset class in the world is a useful addition to their fund offerings. Even if the benefits of the fund are slim in the current bond environment, it is possible that this diversification will be useful in the future. Of course, like all diversifying assets, it has a chance of lowering portfolio return, but at least with bonds, one knows the yield at the outset.

Well 75% of the bond market is outside the US. (Proportionally the US is a much larger chunk of the global stock market than of the bond market.) So from the standpoint of a market-cap weighted passive investor, this fund fills in a huge gap.

As for the diversification benefits, I don't think the Vanguard paper did the right analysis. We aren't really interested in how this impacts the volatility of a balanced portfolio because we've already reduced volatility by about as much as we can without altering our exposure to the basic asset classes.

What we'd really like to know is how this reduces your exposure to "peso problem" events that only occur with very small probability (e.g. 1-2%, or even less). Unfortunately, because of the low probability, it is unlikely that the historic record will be sufficiently illuminating. So what we really need to do is an extreme value analysis that extrapolates out to the tails of the distribution and then estimates the reduction in tail-value at risk. (Which is, confusingly, very different from "value at risk".) Common sense tells us that reducing our exposure to one large issuer (the US Federal Government) reduces our losses in the event of extreme events, but we really don't know how big of an impact this is or what the best allocation to international bonds would be to achieve this.

Similarly, looking at recent-ish history in the US (since the early 80s) isn't sufficient to get a good idea of the diversification benefits of doing this. US bonds were in a very long, very strong bull market for the entire time period. We'd like to know whether or not the global bond market is correlated enough that all bonds will be in bull or bear markets together or whether it is possible for the US bond market to be in a bear market while international ones are still bullish. Again, it seems to me that, in a rising interest rate environment in the US, having the international exposure would leave you better off than otherwise, but I don't know how big of an effect this would be. More data and more analysis is needed.

abuss368 wrote:What happened to the emerging markets bond fund that was to be originally offered with this one?

The Vanguard paper linked in the very first post still has the section talking about the benefits of emerging market bonds. I'd assume that if they didn't plan to launch one that the new version of the bond paper would have taken that section out. So it would seem to be still in the works.